Economics

Housing markets

Buy, buy or bye, bye

JOSH BARRO and Adam Ozimek have been having an interesting discussion of the costs and benefits of home ownership. Mr Barro writes that people vastly overestimate the good things about owning a home. One is typically renting either way; homeowners simply choose to rent capital rather than housing. Homeownership creates perverse incentives; a large share of the population develops an interest in pushing the prices of a critical consumer service higher. And homeownership is a risky, leveraged bet on a single asset—a bet that often represents a large share of household savings.

Mr Ozimek reckons Mr Barro is being unfair. Homeownership may be cheaper than renting because the "landlord" of an owner-occupied home doesn't have to face risks, like extended vacancy or reckless damage to the property, that actual landlords do. What's more, homeownership provides a hedge against rising housing costs.

Both make good points, and both are right to some extent: homeownership makes sense for some households in some circumstances and doesn't for others at other times. But once we start thinking about the role of leverage in housing markets the case for broad homeownership begins to look weaker.

Let's start with the basics. We all need shelter or "housing services"; as the saying goes, everyone comes into the world with a short position in housing. One could obtain housing services by renting them from a landlord, or one could obtain them by purchasing shelter. But shelter is expensive; even in cheap markets production of a single-family home costs more than $100,000 on average. It is relatively difficult to accumulate the savings needed to pay cash for housing, and so homeownership will be less common than renting unless borrowing to purchase is made cheap and easy.

Unfortunately, the introduction of leverage makes things messy. Imagine a city in which the average home price is $100,000 and the average homeowner puts down 10% of the value of a house at purchase. Then imagine that one household decides to use $10,000 in savings to buy a home while another invests $10,000 in savings in shares of a REIT which owns outright a portfolio of representive homes in the city. Then imagine property prices rise 10% per year over the next five years.

At the end of five years, the value of the average house will have risen just over 60%, and the household that invested its money in the REIT will be feeling pretty good, having turned its $10,000 into just over $16,000. But the household that bought will have enjoyed a return of more than 600% on its $10,000 downpayment! At the end of five years, if households still put 10% down for new homes, the buyer can cash out and put its $70,000 or so in equity toward a much grander house than the renter could ever think about affording.

A few things jump out from this example. One is that if there is a reasonable expectation that prices will rise, then in leveraged housing markets renters risk looking like suckers. Another is that in a leveraged world any sustained uptick in prices quickly risks becoming a speculative boom. If those that bought can cash out and buy new homes at prices vastly above the average, the average price starts to rise faster. That feeds back to equity gains and on the cycle goes. Little wonder many people subscribe to Edward Leamer's dictum that "housing is the business cycle".

But why should housing prices rise in this way? New supply should keep them in check, for one thing. If prices rise above production costs then builders can make easy money. Those seeking housing services should always be able to get a better deal buying new construction than an existing home, and home prices should fall to the marginal cost of housing production. But even in liberal housing markets this doesn't necessarily work. It takes time to deliver new housing, and builders may wait to see if price increases are sustained before scaling up construction. In the meantime the credit feedback loop can really get cranking. And of course, lots of housing markets are anything but liberal, and it can be quite hard to add new supply in response to rising prices. Not surprisingly, research indicates that bubbles are much more likely to develop in places with lots of supply restrictions. And as Mr Barro points out, homeowners have a strong incentive to restrict new building to protect the value of their housing asset.

Income growth should provide another check. Rents cannot grow much faster than the rate of income growth or demand will tumble. As the cost of buying rises relative to rents, new market entrants seeking housing services will increasingly opt to rent. As the flow of new buyers dries up, price growth will necessarily slow, tipping the credit loop into contraction. But this process can take a long time to work. New buyers can be enticed into the market through weakened credit standards or reduced downpayment requirements. Money may also flow in from outside the city, from investors who aren't interested in obtaining housing services but who are counting on continued price appreciation. This can keep prices rising well beyond rents and incomes for a long period of time.

One might think that forward-looking lenders should anticipate all of this and act autonomously to tighten lending standards as prices rise. The party can't go on forever, and the longer it does go on the greater the risk of a substantial crash in values. And since buyers are heavily leveraged, losses in value are magnified, raising the risk that price declines become crises. But that's not how markets work in practice. In booms there is plenty of money to be made; it's mostly the dumb money that gets in last that bears enormous losses. There will therefore be investors willing to bet that prices will rise more before they fall. If some lenders curtail their lending out of caution, others will step in. Booms can last a long time before there is no dumb money left.

And so once leverage is introduced, preventing dangerous financial cycles requires government to do two things:

But these steps are bound to be unpopular; lots of rich and influential people and voters will have a direct financial interest in opposing such measures. If governments fail to take these important steps then the economy will face nasty costs: from rent-seeking NIMBYs, and perhaps from the distortions resulting from steps taken to cushion the economy against the fall-out from a crash.

So yes, there are advantages to owning homes in many cases. But is homeownership a good thing overall? In a world where homeownership generally involves substantial amounts of leverage, one's support for homeownership should generally be correlated with one's confidence in the quality of governance. I think I'll leave it at that.